Sunday, 21 September 2008

Structured Products

"If you don't understand it, then don't buy it"

-- Investing legend, Warren Buffett

A BRIEF HISTORY

Structured products include structured investments, structured deposits, capital guaranteed funds and capital protected funds. The word "structured" is rarely used in the marketing and they are usually sold as unit trusts or ILPs (investment-linked products). Most are distributed mostly by banks although insurance companies have recently entered the picture.

In the 1990’s, they were a way for rich individuals and institutions to structure investments to get their preferred mix of risk, return, liquidity, income and capital gain. This was useful.

As issuers got good at structuring, they expanded to the mass market. But how to make a customised product for each and every small investor? It seemed impossible.

It didn’t take long to find a way to “customise for the masses”. The newly developed structured products appealed to the masses and had similarities to gambling. It works like this: A structured product might take 20 well-known stocks, for example, and let people place bets on which three would appreciate the most over 5 years.

The world’s best stock pickers and sports handicappers would be hard-pressed to guess the outcome. In addition, every structured product has an expiry date. These two features make it similar to a wager.

But like all games of chance it is exciting to try one’s luck. Plus it looks like the odds are structured in such a way to give you a big payout if you win.

Add to this a minimum return that is often “guaranteed” (as long as you fulfill other conditions like no early redemption). It appears to be an investment with no risks and good upside potential. Not surprisingly, it has sold very well.

ONE-TIME CHARGES

If you buy a structured product, it will almost certainly be from a bank who are the “distributors”. Their standard fee is 3 per cent of the amount invested. For example, a two-month marketing campaign that raises $100 million would produce $3 million in revenues for the bank.

This 3 per cent distribution charge is deducted from the net asset value (NAV) of the investment. It means if sold immediately after purchase, the investor would receive back 97 per cent of the investment.

The distribution cost does not seem to be excessive and is revealed in the fund’s prospectus (but not the brochures or advertisements). It is in line with initial sales commissions of unit trusts and ILPs (investment-linked products) which charge 2 to 5 per cent.

Distribution costs are one-time costs. If one holds the structured product for a number of years, the average annual distribution costs will be less than yearly fees.

The issuer will also include a charge in the price of the structured product. It is typically embedded in the instantaneous variance component.

ANNUAL CHARGES

Issuers charge annual management fees. They also charge performance fees which can be very high as I will explain.

Issuers are the architects who design the structured product. They also invest the money which the distributor (bank) collects and remits to them. Issuers are also called guarantors and underwriters.

Structured products usually sells in units and are classified as unit trusts. In this case, the must disclose the management fees.

When not sold in units, the issuer will subtract its fees directly from the fund's yield. In that case, there is no way to determine the cost the issuer charges.

The management fee may be higher than it appears, especially for guaranteed funds which invest about 90 per cent of the fund into bonds.

In these cases, the management fee may take a substantial portion from an already low return.

The issuer might take a fixed 1 per cent per year when total returns are between 1 and 5 per cent. It leaves only 0 to 4 per cent for the retail investor.

An example: When a guaranteed fund's return is 3 per cent, an issuer that takes a 1 per cent management fee is taking 1/3 = 33 per cent of the total return.

EARNINGS CAP

Let’s say the structured product is linked to stock returns and these perform well. Then the structured product will also do well. Returns could be quite high.

The high returns do not go to investors because returns are typically capped. It means they cannot go above a certain level.

An earnings cap is typically marketed as a benefit to investors and is called an “early buyout”. This is not correct. It is a drawback. The investor would have made more money if there were no earnings cap.

Usually, it is phrased something like this: “Should your investment do well, then at the end of year 2 you will receive an early buyout with a 5 per cent bonus.”

Scenario 1: Suppose the structured product does well enough to pay its promised maximum returns of 3 per cent in year one and 3 per cent in year two. At the end of year two, it pays the 5 per cent bonus. It means that over 2 years, you will have earned 11 per cent (3+3+5).

Scenario 2: Take a case where the product earns 8 per cent in both years 1 and 2. The total is 16 per cent. You will still receive the pre-determined 11 per cent and no more. The excess profits of 5 per cent (16 – 11) go to the issuer. It is not shared with investors.

Scenario 3: Suppose it was a great year and stocks shot up 26 per cent. The cap is the same and the issuer needs to pay investors only 11 per cent. In this case, the excess returns are even more. They are 26 – 11 = 15 per cent. As before, none of the excess returns go to investors. The entire 15 per cent goes to the issuer.

Nearly all structured products contain caps. It is an upper limit to returns. It guarantees that investors will not participate in high returns when markets are strong. Instead investors will receive a modest bonus in the form of a buyout. (Usually, it is 5 per cent.)

In a strong market, who gets the returns in excess of the cap? For some structured products, it may go to the issuer. For others, it may go to a counterparty to a hedge contract.

Regardless, the derivative portion of the structured product is a fair bet prior to charges. If one party wins, the other loses.

As second level of analysis, one must understand that it becomes a negative-sum investment. This happens when one considers fees of the issuer and distributor.

Those fees are found in (i) the issuing charge that is either (a) charged as a management fee or (b) embedded in the product itself, (ii) the issuer's profits from market-making, (iii) the front-end load charged by the distributor and various hidden fees deducted directly from the yield of the structured product -- such as foreign exchange conversion costs, gains or losses from foreign currency fluctuations, taxes deducted at source and brokerage commissions.

5 PROBLEMS OF STRUCTURED PRODUCTS

The first problem is that many structured products are not traded as unit trusts and do not show the management fee. Instead, issuers will embed their charges in the price of the product itself. As such, it is not possible to know how much you pay for it.

A second problem is the return caps. These limit returns when the product does well, such as in bull markets. It limits the profit potential. It may be fair if the cap is part of the structuring. One could think of it as the price one pays for benefits of the structured product. Typically, however, those benefits are emphasised while the return caps are downplayed.

A third problem is illiquidity. If the investor sells prior to the maturity date, usually 5 years, he must pay a penalty. This can result in getting back less than the initial investment, a loss. Even when the product is actively traded, the issuer will typically act as the market-maker. It is another source of profit for the distributor and another cost for the investor.

A fourth problem is the marketing. It is less than straight-forward and often suggests a higher payout than investors actually receive. For example, it may be promoted as giving a payout 5.5 per cent after 6 months. This works out to 11 per cent per year. That is good. (In fact, it is too good to be true.)

The prospectus always contains an admission (sometimes in hard-to-understand language) that such a high return requires a payout from capital. It means the payout is not a return on investment at all. The bank has simply given back a part of the investor’s own money and called it a “payout”.

Sometimes banks even send a letter congratulating you on receiving a high payout. The tactic seems to be effective and has spread. It has also been used to promote bank deposits and endowment insurance policies.

A fifth problem is the bank's marketing strategy. It advertises a range of returns. Bank staff then suggest to customers that the upper end of that range is likely.

In fact, there is no way to know since structured product returns are based on baskets of shares, bonds, stock indices or currencies. Forecasting the return to each component of the basket over a 5-year period is extremely difficult.

HOW TO RECOGNISE A STRUCTURED PRODUCT

Very often, structured products are marketed as familiar and safe investments: Either a unit trust or an investment-linked product (ILP). Typically, the word "structured" is never used. How to know if you are buying an ordinary unit trust or ILP -- or a structured product?

Usually, the only way to tell is if the return is linked to some other event -- like "no more than 3 stocks in a basket of 20 declining in price each year". Most structured products will also have a buy-out provision. It allows the fund to buy you out if it is moving in the right direction.

Most structured products also advertise high yields. But a part of the yield is often a return of your own investment.

Can structured products be sold under the CPF investment scheme (CPFIS), which permits you to use your CPF money to buy an investment?

The answer is "yes". If the product is sold as a unit trust or ILP, then it is possible that it could be sold under CPFIS. Keep in mind, therefore, that just because a fund is CPF-approved, doesn't mean it is not a structured product.

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A simple girl interested in sharing financial tips and news from the United States and Singapore. Many people focus on how to get rich. But some forget that their eventual objective is to be happy. And some also forget that the best way to be free from poverty and maintain wealth after getting rich is to be free from scams.